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It would be easy to dismiss Fortescue's interim result. The largest pure iron ore business on the market reported dazzling results. Duh. What else would happen when iron ore prices are high?
The numbers themselves are in Table 1 and, yes, high iron ore prices played a large part.
Just about all the US$2.6bn in additional operating profit can be explained by higher prices. That doesn't make Fortescue a hostage to fortune.
Received iron ore prices rose by 75% to over US$80 a tonne. Some of this increase was because of higher benchmark prices; much of it is also because the pricing gap between Fortescue's grade and benchmark grades is narrowing.
A new 60% iron product now accounts for 10% of output. That proportion will rise with new production.
Fortescue Metals interim result 2020
Six months to Dec
Net profit (US$m)
* Wet metric tonne
Fortescue is investing in several new projects, mostly designed to lift grades and improve prices that the miner receives. As a result, capital expenditure for the full year will be well over US$2bn, about twice the levels of recent years.
The Eliwana project will produce grades over 60% iron and Iron Bridge will introduce magnetite - a high grade processed iron product - into the product mix with 67% iron grades. There are also infrastructure projects planned to improve efficiency.
Fortescue, for example, owns a fleet of autonomous drill rigs and trucks as well as robotic conveyer belts and high-quality rail.
Even in the face of likely falls in the iron ore price, higher grades, low costs and a rock solid balance sheet (never thought we'd say that about Fortescue) should offer some protection.
This is a much better business than the one we recommended in Fortescue: options and opportunity. We wonder whether the iron ore price boom has disguised the improvements in quality.
A highlight of Fortescue has been its disciplined capital allocation. Despite copious cash flows over the boom, it has invested wisely and paid dividends generously. This year Fortescue should pay at least $1.50 in dividends implying a running yield of about 13%, fully franked to boot.
Most yields of that scale come from dangerous situations and serve as a warning. In this case, the high yield reflects the expectation of lower iron ore prices. That is probably correct, but no one knows.
Output from Brazil remains absent and management suggests that, as long as coronavirus is contained within the quarter, there will likely be no impact to Chinese cargoes. Fortescue might still be cheap.
That, of course, is the art of resource investing. The numbers will always flatter at the wrong time; high prices invite comfort and we forget that these are cyclical businesses.
For those still holding Fortescue, this ought to be a time to reduce your holding, especially since the impact of coronavirus could be potentially large and is absent from the share price.
If iron ore prices hold, Fortescue remains on a free cash flow yield of close to 15%. As the share price approaches our Sell price, however, we ought to resist being seduced by numbers and reduce portfolio weightings. HOLD.
Disclosure: The author holds shares in Fortescue.
Gaurav Sodhi is the Deputy Head of Research at Intelligent Investor. For more share research from Intelligent Investor, start a 15-day free trial.